Let's say an arsonist sets fire to a building in a crowded area in order to collect the insurance. The fire brigade may demolish the next couple of buildings to prevent the fire spreading - even if this is a little hard on the innocent people who live there.

What's happening in the wake of the benami demat accounts scandal is similar. A bunch of scamsters have been manipulating the IPO market for at least two years. The market regulator, Securities and Exchange Board of India is now taking action to stamp out the scandal. In the process, it will inconvenience many lakhs of retail investors. Including you.

The modus operandi of the scam was simple: Unscrupulous financiers created multitudes of fictitious demat accounts, made multiple IPO applications using those accounts, collected the fraudulently obtained shares and sold them. This could not have been done without the collusion of depository participants and the "cooperation" of lead-managers who looked the other way. While Sebi has not indicted any lead-manager (yet), it has initiated action against an impressive list of financiers and DPs.

IPOs have in-built checks and balances. Every IPO application must come through a demat account. It's a DP's responsibility to prevent fictitious accounts. Under "know-your-client" norms, the DP must check out every demat application. The DP list reads like a who's who of the Indian financial services industry.

But in practice, any system is open to abuse. The KYC norms have been ignored time and again by dozens of DPs. And, the indicted DPs include some of the most trusted financial institutions such as Karvy Securities, Motilal Oswal, HDFC Bank, IDBI Bank, etc.

The embers started flying last year when Sebi investigated allegations of irregularities in several large IPOs. What it unearthed was startling: Over 50,000 obviously fictitious demat accounts were active along with associated fraudulent bank accounts

Well, Sebi lowered the boom in no uncertain terms in its 27 April interim order. It banned some 85 financiers from stock market operations and barred a long list of DPs and executors from proprietory trades and demat operations.

Well and good: Sebi is creating a fire-break. But what do you do if you are one of these retail investors who hold a demat account with a banned DP? How do you protect yourself from the fallout? In the following, we take a look at Sebi's actions, inaction and the likely course of future events. And, then, we offer a survival guide.

Who's Guilty?

Sebi's third interim order passed on April 27 is intimidating in its sheer size - it's 252-page long. It's a follow up to two previous orders. It's unclear when the investigations will be concluded and the final orders passed. The first interim order of December 15, 2005 focused on the Yes Bank IPO of June 2005. The second order of 12 January was mainly about Sebi's investigations of the Infrastructure Development Finance Company's IPO of July 2005. In mid-February, Sebi also officially requested the CBI to intervene. It's a little strange to see the same crime being investigated by two different agencies.

Though the new order offers some revelations about the extent of the rot in the DP system, the bulk of the findings is the same as in the previous two orders. The list of financiers has now expanded to about 80 and the number of IPOs to 21. The illegal profit made by the financiers in the IDFC IPO (which Sebi covered in its 12 January order) by selling shares from over 50,000 fictitious allottees' fictitious demat accounts through the executants was the highest. The ungodly garnered some Rs 43 crore (Rs 430 million) out of a total of Rs 73 crore (Rs 730 million) in illicit gains in that one IPO (See table: The Loot and the Looters).

In the IDFC IPO case, Bhanuprasad Trivedi, Excell Multitech, Sujal Leasing, Seer Finlease, Jayesh P, Khandwala HUF, Taurus Infosys, Gautam N Jhaveri, the Lalwanis and Amadhi Investments were among the biggest financiers-cum-illegal beneficiaries. Financiers newly named in Sebi's latest order encompassing another 20 IPOs include Anagram Securities, Dushyant N Dalal, the Dadias and Ketan Atul Doshi. There is no addition to the list of large executants like the Panchals, Sugandh Estates and Purshottam Budhwani.

Also, the outside contributors (witting or unwitting) who allowed fictitious applications and accounts to seep into the system remain more or less the same. These include the biggest lead managers like SBI Capital Market, Kotak Mahindra Capital and DSP Merrill Lynch; DPs like Karvy Stockbroking and Pratik Stock Vision (with the highest number of fictitious demat accounts) and banks like Bharat Overseas Bank and Vijaya with the highest number of fictitious bank accounts.

Sebi Nets Some Fish...

Sebi, in its 27 April interim order:

Banned 24 executants (used as agents by financiers) and 85 financiers from dealing in the securities market.

Suspended all operations of two DPs–Karvy Stock Broking and Pratik Stock Vision–indirectly asking their over one lakh investors to shift their demat accounts.

Directed NSDL to inspect 15 DPs with more than 500 demat account holders sharing common addresses.

Directed NSDL and CDSL to revamp managements.

Referred banks involved in opening benami bank accounts to the RBI.

These actions remain in force till the inquiry is complete.

But Others Slip Out of the Net

Astoundingly, Sebi has been soft on the most important primary market players–the issuer companies and the lead managers. There is not one mention of the lead managers' roles. The Sebi (Disclosure and Investor Protection) Guidelines that govern all pubic issues are quite clear. Schedule II lays down the lead managers' "inter se allocation of responsibilities" and among them are "post-issue activities which must include weeding out of multiple applications".

The IPO benami fraud involved a single person calling the shots with regard to different individual applications. But the effect was the same as one person making multiple applications. Lead managers ought to have been actively looking out for this.

Computerised systems at the registrar's end enables simple scrutiny of applications with the same address. The IDFC IPO, for instance, had three lead managers - SBI Capital Market, Kotak Mahindra Capital and DSP Merrill Lynch. Had they scrutinised applications with common addresses, the scam would have been scotched.

Why did Sebi not resort to heavy monetary penalties on the negligent DPs instead of freezing all demat accounts? Sebi's says (See interview: 'One Order not Enough') it cannot, "except by way of enquiry-cum-adjudication proceedings". Sebi has all the powers required to impose fines under its adjudication regulations.

But it has not, so far, initiated proceedings under these regulations. It has also faced difficulty in enforcing its bans with stay orders granted by two different courts and a successful appeal by Indiabulls (See box: Caveat on Sebi). Several other DPs appear confident that they can wriggle out. The 12 DPs debarred from opening fresh demat include prominent names and most say that they would make their submissions to the appropriate authorities within the allotted time for appeals.

A spokesperson from Motilal Oswal where irregularities were observed in 697 accounts said, "While the irregularities pointed out do exist, they are minor. They are things like signature is not there across photographs, signature is there but date is not mentioned, identity proof not clearly visible and bank account details (which are not mandatory) are not mentioned and all these accounts are not IPO accounts. The order against us is harsh. We have tallied the discrepancies at our end and are in discussion with Sebi for further recourse."

What Sebi Should Do

Sebi should spread the net. As we've said, lead managers have completely escaped punishment despite failing to weed out multiple applications at the processing stage. In fact, in an "IPO scam", the biggest primary market players, the lead managers, have not been taken to task at all.

The allure of the 5-30 per cent positive difference between IPO issue price and the listing day price also depends on being allotted a significant number of shares. Allotment is dependent on the biases of lead managers and not all applicants are allotted shares.

While replying to Sebi's first show cause notice to NSDL in the Yes Bank IPO case, NSDL suggested in its 31 December 2005 letter: "The problem of multiple applications in primary issues is not new. Sebi had in the past introduced proportionate allotment to remove the incentives for multiple applications. NSDL has recommended to Sebi to examine whether this needs reintroduction."

Sebi needs to remove the varying allotment basis among investors. For instance, the retail portion of Yes Bank IPO was oversubscribed 10 times and if true proportionate allotment had been in place, every applicant would have guaranteed allotment of 15 shares from the required minimum application of 150 shares.

Instead, as per Sebi-permitted basis of allotment, a minimum of 150 shares had to be compulsorily allotted to every allottee. As a result, three out of every 29 applicants (who applied for 150 shares each) got full allotment. The returns were higher if you applied for 1,050 shares - 26 out of every 37 applicants received allotments of 150 shares each.

The financiers behind the Panchals and Sugandh put a lot of financial muscle behind the 1,050 shares applications knowing that their thousands of benami applications would be allotted 150 shares each. In a true proportionate system, they would have managed only allotments of 105 shares (one-tenth of 1,050) per benami application.

Sebi is clearly not interested in reviewing the allotment basis. Says N. Hariharan, deputy general manager (communications) at Sebi: "As far as the integrity of the IPO process is concerned, it may be mentioned that there are no systemic issues necessitating a revision of the process."

RBI's Responsibilities

It's mandatory to quote your bank account number in the demat account opening form. Therefore, each of over 50,000 fictitious demat accounts is associated to a fictitious bank account. Your IPO investing experience is dependent on RBI's pulling up errant banks and plugging the loopholes that allowed opening of these fictitious accounts.

With big names like ICICI Bank, HDFC Bank and IDBI Bank involved, how can the investor be assured of safety? The RBI was unresponsive when we asked about its actions in relation to the involvement of various banks. Says Kirit Somaiya, president, Investors Grievances Forum: "At least Sebi has shown some courage to hunt down culprits. The RBI is unnecessarily avoiding action and continuously covering up for the banking system."

RBI has also been inconsistent in the action it has taken against banks (See table: Disconsonant RBI Penalties on Banks). That's because RBI has also taken into account the banks' involvement in IPO financing and the lack of due diligence in monitoring end-use of loans. The Banking Regulation Act empowers RBI to impose a maximum penalty of Rs 500,000. Hence, banks like Bharat Overseas Bank and Vijaya Bank have escaped with light fines despite significant contributions to the IPO scam.

In conclusion, the only real power that you possess as an investor is to avoid investing in IPOs if you feel the regulator will not protect your interests. Instead you can focus on the secondary market - of course you'll need to ensure your demat account is operative. Our survivors' guide tells you how to do this. All the best!

Caveat on Sebi

Sebi is finding it tough to enforce the suspension orders of its April 27 interim ruling. Appeals against Sebi must be made to the Securities Appellate Tribunal, but Karvy Stockbroking and one indicted financier Saumil Bhavnagari have instead made separate appeals at high court level.

Sebi has so far not made public what counter-action it intends. Karvy Stockbroking was banned from all operations, including continuing with its existing clientele. It challenged the order in the Andhra Pradesh high court.

On May 2, the high court stayed the order to the extent of Karvy's existing demat account holders having to mandatorily shift to any other DP. The high court upheld that part of Sebi's order where Karvy cannot carry on proprietary trades as stockbroker or DP.

Saumil Bhavnagari, (one of some 80 financiers banned from stock market trades) appealed to the Gujarat high court at Ahmedabad.

On May 4, the court stayed Sebi's order in so far as it pertained to Bhavnagari and only as long as Sebi heard Bhavnagari's representation in his defence. Even stranger was the case of Indiabulls Securities. Indiabulls was one of the 24 executants banned from proprietary trades.

In the TCS IPO of August '04, Indiabulls received 14,000 shares in its proprietary account from 560 demat accounts. It transferred 17 shares to Ajay Kumar Gupta (a financier indicted separately). Sebi apparently has not been able to establish that the remaining shares were either sold or transferred.

On April 28, Sebi amended its April 27 order: "... on the basis of oral and written submissions made by Shri Sameer Gehlaut, chairman, Indiabulls Securities Ltd - the ex-parte ad interim order dated April 27, 2006 - in so far as it relates to Indiabulls Securities Ltd. would be kept in abeyance subject to verification of clients and until further directions."

Do you think the action taken in your order is adequate to protect investors' interest - and the integrity - of the IPO process? What else needs to be done?

No single order can be deemed adequate to protect investors' interests. As far as the integrity of the IPO process is concerned, there are no systemic issues necessitating a revision of the process.

All systems are prone to abuse by wily operators who conduct themselves in a manner not consistent with laws, rules or regulations. The appropriate response is not necessarily to revisit the process but to apprehend and deal effectively with those who manipulate prescribed processes.

Your action against Karvy and Pratik DPs involves suspension of operations and includes closure of existing demat accounts of their investors. Instead of causing this inconvenience to investors, why didn't Sebi resort to monetary penalties?

No penalty - monetary or non-monetary - can be imposed on any DP or any other market participant except by way of enquiry-cum-adjudication proceedings.

What is the rationale behind banning of opening of new demat accounts by 12 other DPs? Where can retail investors go if the DP of their choice has been banned?

If any party is aggrieved by the ex-parte order (of April 27, 2006), he can file objections and seek personal hearing within 15 days. While the prohibition remains on the mentioned DPs, retail investors would have to approach other DPs. As on March 31, 2006, there are some 223 NSDL DPs and 315 CDSL DPs active.

The order states that Sebi advised BSE and NSE to look into dealings in shares pre-listing of IPOs. What was the rationale? SEs monitor trades on their systems. Off-market transactions are under Sebi's sole purview.

The advice was for examining the concentration, trading pattern, price discovery and volatility on the first day after listing in respect of IPO shares which went through a series of off-market transactions before listing.

The Survivor's Guide

You are affected by Sebi's actions and inaction. The effect is direct if you have a demat account with Karvy Stockbroking or Pratik Stock Vision. You're also inconvenienced if you were about to open an account with any of the 12 DPs banned from opening new accounts. It's prudent to assume more fallout from the scam.

What should you do to survive the turbulence?

Don't panic, if you're forced to close your existing demat account. Within the stipulated time, you can transact and effect deliveries from the affected account. Your shares will not be lost even if you couldn't close within the stipulated time. You can still transfer shares from the account to another DP. If you have given physical shares for demat, they will be credited and you can shift them later. The same applies for shares pledged as loan-security, which are returned after the loan is repaid.

Decide which depository's DP you opt for. Sebi has passed strictures against both NSDL and CDSL, for their negligence. It found that while NSDL regularly inspected its DPs, the sample size was "woefully inadequate".

Sebi concluded that "NSDL was aware of the irregularities in connection with opening of accounts from 2003 which is evident from the inspection report of HDFC Bank, Karvy Stock Broking, etc. They failed to take prompt action and to inform Sebi of the same." In CDSL's case, the findings are worse. Sebi found that "CDSL gets its inspection conducted by outside professionals. The inspection reports are not indicative and it is very difficult to draw conclusions as it is in 'Yes' and 'No' format." This indicates irregularities would never even have been captured by CDSL in its inspection reports. Given the track record of both depositories, we believe that NSDL is a safer option.

You just have to live with the inconvenience of waiting 5-7 days for the new account. S.M. Dawla, a Guntur-based demat account-holder with Karvy, says: "There are only two other DPs with branches here in Guntur and I have run from pillar to post to open a new account. I have selected a bank-DP but it is taking a long time to complete formalities."

Put in due diligence in choosing your new DP. In the long run, it is a valuable investment of time. The 14 DPs indicted by Sebi include big names like HDFC Bank, Sharekhan, Motilal Oswal Securities and of course, Karvy Stockbroking. More DPs may be picked up in future investigations. If the trouble was restricted to one specific branch, your DP is probably stable. Do see if an indicted DP takes corrective steps. For instance, HDFC Bank has sacked an unspecified number of officials for involvement or collusion. Look out for such actions and if necessary, ask the DP directly. It is in the DP's interests to be transparent with its clients and otherwise, junk that DP.

If the DP charges account opening fees for the account, you'll have to pay. Dawla's chosen DP, for instance, is charging about Rs 600 to open the new account.

Sebi, which could have helped by mandating DPs to waive the opening charges in this case. That, however, was not part of the IPO scam order. You can write a letter to Sebi or email hariharan@sebi.gov.in

1Sebi's earlier interim orders on Yes Bank and IDFC IPOs revealed 51,000 benami accounts; The latest order has no fresh details2All unspecified cases will add up to not more than about 6,200 benami bank & demat accounts